Income tax planning – how Rockbridge can help

It’s tax time again and as you gather your W2s, 1099s, and maybe even your K-1s, we thought it would be a good time to explain our income tax planning approach.

Income tax planning is a crucial aspect of the overall financial planning process. To some degree, taxes impact every area of your financial plan. In certain cases, the tax planning opportunity will be a one-time event; affecting only one or two tax years. Other times, tax decisions will have an impact on multiple tax years well into the future.

At a high level, tax planning consists of the following elements:

• Accelerating or delaying controllable income
• Accelerating or delaying controllable deductions
• Structuring your investment portfolio to maximize the tax advantaged characteristics of income
• Converting future taxable income into tax protected income

The basis for tax planning involves reviewing and understanding your current year tax situation, and how it compares to projections of future years. Throughout the year, we review the income you’ve received and expect to receive, along with the deductions you’ve taken and expect to take. This will give us an idea of your expected Federal and State marginal tax bracket.

Your projected current year tax situation will be reviewed against what we would project next year’s tax situation to look like (at least on a high level). Based on this comparison, we can make decisions to accelerate or delay income and deductions, to the extent possible.

Tax planning impacts how we approach constructing your portfolio. We pay attention to the different tax characteristics of income, and how that is affected by being held in accounts with different tax structures.

Distributions from Traditional IRAs are taxed at ordinary income rates, which are generally much higher than long-term capital gains or qualified dividend rates. Holding investments we expect to produce income subject to these tax advantaged rates in an IRA causes this income to lose its tax advantaged characteristic when distributed. Therefore, we try and hold as much of your allocation to bonds as possible in your IRA and hold your stock allocation in your Roth and taxable accounts

Finally, we look for opportunities to convert future taxable income into tax protected income. Examples of this include funding 529 Plans and Health Savings Accounts (HSAs). The investment gains and earnings in these accounts will avoid income tax as long as they are used to pay for qualified education and medical expenses. Directly funding and/or converting pre-tax dollars into a Roth IRA shields future investment gains from income taxes.

We do not let taxes alone drive the decisions we make. However, we do consider their impact and look for ways achieve our planning goals in the most tax efficient way possible.